CMCI: Using a Constant Maturity Approach to Commodities
The Constant Maturity Commodity Index Approach
ROLAND MORRIS: With the Constant Maturity Commodity Index approach [CMCI], one of the things I think is elegant about the Index, is the way that it rolls. Most indices roll and have to pick a roll period. Most of the major large indices roll early in the month. The Morningstar Long Flat Commodity Index happens to roll late in the month, but again, is holding front-month contracts. The Constant Maturity Commodity Index is extremely unique. It essentially rolls its exposure every single day. The hedge is managed by rolling small numbers of contracts out the curve. Once it selects its target exposure, it maintains that exposure on a daily basis. Importantly, it also rebalances on a monthly basis. If a commodity has had strong performance in a month, it will reduce that exposure back to the target weighting. If a portion of the curve has had a strong performance or under-performance, it will re-weigh the curve back to its target exposure. It's an extremely important approach that reduces volatility, maintains exposure, reduces roll risk (both positive and negative), and is an excellent approach to having a long exposure to commodities.
MORRIS: CMCI is an excellent approach to the commodity space. It has what I consider a very elegantly designed approach to its commodity exposure. First of all, it initially picks exposure based on developed world GDP and CPI figures. That selects its exposure by sector. When it selects commodities individually, it has a component on liquidity, which is based on open interest end volume. The Index selects the individual commodities based on consumption. It looks at a consumption filter and filters it by volume and open interest to make sure it's maintaining liquidity. By moving way out the curve, substantially further out the curve than most generation one indices, it creates a much lower volatility approach. It is 100% invested, but its selection process is unique and the maturity is unique. It can remove to the extent possible in the market, positive or negative roll risk. I think it's a very important difference from other commodities indices and makes its approach unique.
MORRIS:The CMCI approach selects commodities using GDP and CPI figures from the developed world. As the emerging markets continue to grow, they will look more like developed markets. That is, in my opinion, a very good approach to selecting its exposure. As a result, it ends up with a much higher exposure than other indices to industrial metals. I think that's an important factor especially during strong growth periods. When we're in a strong growth period, industrial metals will perform extremely well. Many other indices don't have quite the same exposure.
CMCI: Isolating Pure Price Exposure
MORRIS: One of the most important things about CMCI is the constant maturity approach. But if you look at commodity indices, there are three drivers of returns. It's the commodity movement, it's the use of collateral, and its roll risk (positive or negative). In the late 70s, we happened to have all three working: high interest rates, positive roll, and appreciating commodities. We haven't had that situation again and we're probably not likely to have that exact mix. CMCI essentially eliminates roll risk, to the extent possible, and has actually proven to do that.
Amongst the three drivers, given the commodity exposure, the roll exposure, and the collateral exposure, CMCI does a great job of isolating the commodity exposure. It does that, as I mentioned, through its constant maturity approach to reduce the roll risk. It maintains a very short-term bill holding, Treasury bill holding, which essentially eliminates collateral risk. Many newer funds are taking risk with collateral because of low interest rates. They are trying to generate some income stream in that component of the return stream. The problem with that, in my view, is from a long-term macro point of view, when we get into a stronger growth profile or we're generating some inflationary pressures, is precisely when we don't want exposure to duration or credit risk. At the time when commodities are likely to perform well, your exposure to collateral risk can actually hurt the return. I think the nice thing about the CMCI Index is if you're looking for that commodity risk and you want to isolate it, CMCI does the best job of what's available in the marketplace of isolating the commodity risk.&
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The UBS Bloomberg Constant Maturity Commodity Index (CMCI) is composed of futures contracts on 28 physical commodities and buys and sells contracts with maturities of three months and, for some commodities, up to three years. The Morningstar Long/Flat Commodity Index is a fully collateralized commodity futures index composed of 19 commodities that employs a risk-managed approach to commodities, turning “flat” or moving to cash if signals indicate falling commodity prices.
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